What Happens if I Default on My 401k Loan? (must know tips!)


default 401k loan lg

In an emergency, you may decide to borrow some money from your retirement account. 401k loans are quick and do not require credit checks because it is your own money. But have you ever wondered, “What happens if I default on my 401k loan?”

When someone defaults on a 401k loan, they must pay income tax on the portion of the loan not repaid and additionally face a 10% penalty unless the recipient is 59 ½ years of age or older.

401k is a retirement account where employees allocate a portion of their wages to be automatically saved every month. In addition, your employer can also add some money to it as a farewell gesture.

The federal law indicates that the maximum amount you can borrow from a 401k is 50% of the vested account balance or $50,000, whichever option is lesser. We all know it is your money, and you will get it eventually.

However, loan default may have dire consequences.

Suppose you borrowed from your 401k retirement assets. However, you are struggling with the loan repayment. Read on to find out! This article covers everything you MUST KNOW.

In over your head? Find Your Best Personal Loan Option can help!

If you’re in a situation where you think a personal loan might make sense to consolidate credit cards, pay off student loans, or take care of some much-needed home repairs, the folks over at iCash Loans make it easy to get the best offers in under 2 minutes. And it’s WAY better than cashing out a 401k early or defaulting on your 401k loan!

You can even get a loan for as little as a hundred bucks.

You could possibly save thousands a year and you have nothing to lose in checking! It doesn’t even ding your credit score to look at the offers!

CLICK HERE to see how much you can borrow! Apply in seconds and often, you can get the funds in your bank within 24 hours.

What is the penalty for defaulting on a 401k loan?

The penalty for defaulting on a 401k loan is 10%.

In a way, it’s like double taxation but also a disruption to your retirement funds since you’ll now have less to pull when you’re actually in retirement.

Although a 401k loan can be described as a personal loan, there are consequences to default loans. One of the penalties for defaulting on the outstanding balance is tax consequences.

Let us imagine this scenario:

You took a $20,000 401k loan. However, you were unable to make any payments before defaulting. As a result, you will pay income tax on the $20,000 you did not repay.

In addition, you are liable to pay taxable distribution if you are less than 59 and half years old. Therefore, you will pay a 10% federal tax penalty for early withdrawal. Also, interest on the 401k loan is not tax deductible on the amount of the loan.

Another penalty for defaulting on a 401k loan adversely affects your retirement money. A default on a 401k loan tells your 401k plan administrator that you are withdrawing. Therefore, the employee’s 401k vested balance will reduce.

The default loan will be offset against your 401k account balance.

However, you can make an enormous contribution to the plan to avoid a permanent dent in your retirement nest egg. Also, take note that the contribution must not exceed the IRS limits.

Furthermore, some plan sponsors will not allow you to make regular contributions until you complete the 401k loan payments. Therefore, you miss the matching contributions made by the company into your 401k account. Understand the loan agreement before you start saving.

A new policy by the Tax Cuts and Jobs Act (TCJA) indicates that an individual with an outstanding loan balance has until the tax filing deadline to repay a 401k loan from a previous employer.

In addition, they can file for an extension, and no penalties or taxes will be incurred on meeting the new deadline.

Meanwhile, a 401k loan default is often considered an actual distribution or withdrawal. A bigger distribution puts you at risk for a bigger early distribution penalty (federal taxes and state taxes).

Do I have to pay back a defaulted 401k loan?

No, you do not have to pay back a defaulted 401k loan.

The typical cause of 401k loan default is a voluntary or involuntary loss of employment. Suppose you do not lose your job. You can devise loan repayment methods, usually; an automatic payroll deduction until the loan is fully repaid.

Another option is for the employee to take responsibility for deciding the frequency and amount to pay back. However, this leaves room for defaulting. Usually, participants take a 401k loan as a last resort to solve their needs.

A loan is considered in default if the remaining balance is not remitted after 60 days of employment termination. Suppose you cannot pay it back. The loan becomes a 401k distribution or withdrawal.

Do not forget the tax consequences associated with this decision.

Many individuals rely on their 401k retirement plan to live a good life when they stop working. Therefore, it is not a good idea to keep borrowing it to settle heavy financial needs. However, when you run out of options, you may need to make a 401k hardship withdrawal to solve the financial hardship.

The importance of emergency funds cannot be overemphasized. 

It ensures you can solve any emergency without borrowing from banks or your 401k account. You can find editorial content on my website; here is a recent article that details how emergency funds protect your wealth.

Just click that link to read it on my site.

Do 401k loans get reported to credit agencies?

Employers do not report default 401k loan accounts to credit bureaus. Therefore, the inability to keep up with loan repayments will not affect your credit score. In addition, the unpaid balance of 401k loans will not be included in your credit report.

Instead, defaulting on this type of loan will prompt the plan administrator to file an IRS form 1099-r. The purpose of the form is to indicate the amount of tax you owe the IRS. In addition, you need to pay the annual income tax returns by the 15 of April of the following year. Also, you can calculate the federal tax return.

However, if a 401k loan defaulter needs to apply for a mortgage, they may ask for such information and record it as debt.

Can I turn my 401k loan into a withdrawal?

Yes, you can turn your 401k loan into a withdrawal.

Depending on your 401k plan, you can qualify for a hardship withdrawal. IRS may approve withdrawal for an immediate need such as foreclosure, purchase or repair, or primary residence (excluding mortgage), tuition payments, and medical expenses.

Discussing with your employer to fully understand the 401k plan is essential.

Some types of 401k plans also permit a non-hardship withdrawal. Other situations that allow a penalty-free withdrawal include active military duty, child support, medical expenses, funeral expenses, spousal support, and disability.

In addition, you can withdraw from your 401k plan without penalty according to IRS rule 72(t). This rule indicates that you can withdraw a particular amount depending on your life expectancy. However, the money you are stipulated to collect is only substantial if you are close to your retirement age.

Furthermore, the CARES Act allows individuals who tested positive for Covid (or a family member) to be eligible for early withdrawals from their 401k account. However, the maximum loan amount that can be accessed is $100,000 without tax penalty.

Most 401k plans allow participants to obtain service distributions. Therefore, plan participants may seek this option during a hard time.

How do I pay back my 401k loan?

Here are a few steps to pay back your 401k loan:

Pay from your paycheck

Suppose you get a 401k loan from your employer. You may be required to pay back an agreed monthly fee once you get your paycheck.

In this case, the employer deducts the agreed amount before you get your paycheck. This is arguably the best option to pay back a 401K loan. You don’t have to take any responsibility until the loan is repaid. Therefore, equal payment is deducted.

Following termination of employment, you can choose to make a periodic payment or make a considerable contribution to offset the loan. However, it is crucial to repay the full amount before the due date to avoid a distribution penalty. Any unpaid 401k is a taxable amount.

A voluntary job change after obtaining a 401k loan is not usually a good idea. However, you can opt to use credit cards to pay back the loan.

A new 401k plan

Taking a new 401K plan is only applicable if you have new employment. For example, you have an outstanding 401k loan with your former employer. However, you are unable to meet up with the periodic payments.

Taking a new 401k loan with the new employer to pay off the old loan from your previous employer is a good option. Therefore, the new employer will deduct an agreed amount before handing in the paycheck.

Take a distribution

Suppose you are unable to pay back the loan. You can withdraw the rest of the money from your 401k plan.

Remember that a 401k withdrawal is permanent. Therefore, you do not need to pay it back. You can withdraw the rest of your 401k loan to offset the loan. However, if you are less than 59 ½, tax and other penalties will be charged on the withdrawal.

You may need to seek legal advice to determine what is deemed distribution. In addition, you may request the plan document to obtain general information about what is allowed.

NB: A cure period may be permitted for some 401k plans, especially if you are still with the employer. The aim is to protect the retirement savings and allow the plan sponsors to perform their fiduciary responsibilities.

In simpler terms, a cure period extends the repayment window to the last day of the calendar quarter after the end of the calendar quarter when the payment was due.

How long do I have to pay back the 401k loan?

The time you have to pay back a loan is five years. However, you can have a longer duration if the loan was used to purchase a primary residence. The IRS requirements indicate that you must pay the loan quarterly in equal installments through the repayment period.

NB: Some believe it is better to obtain a home equity loan to purchase a primary residence. This option is only suitable if you have a dependable income. The repayment window can be up to ten years or more.

Most 401k loans require a monthly payroll deduction of an agreed amount. In this case, an agreed amount is automatically removed from your bank account on payment of the monthly salary.

However, you may have the option to opt out of payroll deduction. This method poses a risk of defaulting payment. Therefore, you may risk owing taxes and a penalty when the outstanding balance is classified as a distribution.

Furthermore, you have to pay back the 401k loan with interest. The plan administrator determines the interest rate depending on the prime rate. However, the repayment schedule may be similar to what banks offer when you get a loan from them.

Now, you may wonder who gets the interest you are paying. The good news is that the interest is not paid to the employer. Instead, the interest is added to your 401k account. Remember, the money in the 401k account is yours, and so is any interest on top of it.

Do you have to claim a 401k loan on your taxes?

No, you do not have to claim a 401k loan on your taxes. Any 401k loan is tax-exempt, provided you pay it back when it is due. The only consequence you may face is the interest on the loan. Although it is called interest, the money goes straight into your 401k account.

Suppose you obtain a 401k loan. You are required to pay back the loan with interest using after-tax dollars. When you take out the money after retirement, you still have to pay income tax and the tax you paid earlier. As a result, you pay double tax to the government.

401k loans have low-interest rates, so the concept of double taxation may be overlooked. However, this is not the case if the 401k loan is huge and repayment takes many years.

What happens if I take a loan from my 401(k), then lose my job?

Conclusion

A 401k plan is an investment that offers an opportunity for workers to live a good life after retirement. However, if you are in dire need of money, you can borrow from the 401k plan.

When you default on a 401k loan, you stand to suffer double taxation. In addition, your retirement savings plan may fall into chaos. 

You can read a recent article that discusses the best ways to save for retirement. But a 401k isn’t your only option, and in 1 case especially, a Roth IRA might be vastly superior.

Just click that link to read it on my site.

A 401k loan is quite different from a 401k withdrawal. No tax or penalty is associated with the loan, provided you pay it back as agreed. However, a withdrawal means you owe income taxes and a 10% early withdrawal penalty if you are less than 59 ½.

An individual needs to be financially free irrespective of age. 

Financial freedom helps you live the best life. The editorial team has uploaded a recent article on the keys to financial freedom.

In over your head? Find Your Best Personal Loan Option can help!

If you’re in a situation where you think a personal loan might make sense to consolidate credit cards, pay off student loans, or take care of some much-needed home repairs, the folks over at iCash Loans make it easy to get the best offers in under 2 minutes. And it’s WAY better than cashing out a 401k early or defaulting on your 401k loan!

You can even get a loan for as little as a hundred bucks.

You could possibly save thousands a year and you have nothing to lose in checking! It doesn’t even ding your credit score to look at the offers!

CLICK HERE to see how much you can borrow! Apply in seconds and often, you can get the funds in your bank within 24 hours.


Image by Natalia Ovcharenko from Pixabay and Image by Steve Buissinne from Pixabay


Of course, while I have decades of personal and business financial experience, and have dealt with judgments and credit issues many times, I am not a credit repair expert, CPA, or financial attorney, nor do I live in Florida (where the laws are subject to change). Thus, my article should not be construed as financial or professional advice. If you need professional advice, you should seek out a qualified professional in your area.


Top Related Posts